Review of the previous lecture

Nominal interest rate

equals real interest rate + inflation rate.

Fisher effect: nominal interest rate moves one-for-one w/ expected

inflation.

is the opp. cost of holding money

Money demand

depends on income in the Quantity Theory

more generally, it also depends on the nominal interest rate;

if so, then changes in expected inflation

affect the current price level.

Review of the previous lecture

Costs of inflation

Expected inflation
shoeleather costs, menu costs,
tax & relative price distortions,
inconvenience of correcting figures for inflation

Unexpected inflation
all of the above plus arbitrary redistributions of wealth between
debtors and creditors

Review of the previous lecture

Hyperinflation

caused by rapid money supply growth when money printed to finance

govt budget deficits

stopping it requires fiscal reforms to eliminate govts need for printing

money

Lecture 21

Open economy - I
Instructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400

Lecture Outline

1. Open economy
2. Saving and investment
3. Three experiment

Open economy
spending need not equal output
saving need not equal investment
Preliminaries

C Cd Cf

I I

G Gd Gf

superscripts:
d =spending on
domestic
goods
f = spending on
foreign goods

EX = exports = foreign spending on domestic goods

IM = imports = C f + I f + G f = spending on foreign goods
NX = net exports (a.k.a. the trade balance) = EX IM

Open economy
GDP = expenditure on domestically produced g & s

Y Cd I

G d EX

(C C ff) (I I ) (G G f ) EX
C I G EX (C ff I G f )
C I G EX I M
C I G NX

Open economy
The national income identity in an open economy

Y = C + I + G + NX

or,

NX = Y (C + I + G )
domestic
spending

net exports

output

Open economy
Trade surpluses and deficits

NX = EX IM = Y (C + I + G )
trade surplus
output > spending and exports > imports
Size of the trade surplus = NX

trade deficit
spending > output and imports > exports
Size of the trade deficit = NX

Open economy
International capital flows
Net capital outflows
=S I
=net outflow of loanable funds
=net purchases of foreign assets
the countrys purchases of foreign assets
minus foreign purchases of domestic assets
When S > I, country is a net lender
When S < I, country is a net borrower

Link between trade & cap. flows

The link between trade & cap. flows
NX = Y (C + I + G )
implies
NX

= (Y C G ) I

=
S
I
trade balance = net capital outflows

Thus,
Thus,
aacountry
countrywith
withaatrade
tradedeficit
deficit((NX
NX<<
00))
isisaanet
netborrower
borrower((SS<<II).).

Saving and Investment in a Small Open Economy

An open-economy version of the loanable funds model includes

production function:

Y Y F (K , L)

consumption function:

C C (Y T )

investment function:

I I (r )

exogenous policy variables: G G , T T

Saving and Investment

National Saving:
The Supply of Loanable Funds

Saving and Investment

Assumptions re: capital flows
a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)
b. perfect capital mobility:
no restrictions on international trade in assets
c. economy is small:
cannot affect the world interest rate, denoted r*

aa &
& bb imply
imply rr =
= r*
r*
cc implies
implies r*
r* is
is exogenous
exogenous

Saving and Investment

Investment:
The Demand for Loanable Funds

Investment is still a
downward-sloping
function
of but
the the
interest
rate,
exogenous
world interest rate
determines the
countrys level of
investment.

Saving and Investment

If the economy were closed

the interest
rate would
adjust to
equate
investment
and saving:

Saving and Investment

But in a small open economy

the exogenous world

interest rate
determines
investment
and the difference
between saving and
investment
determines net
capital outflows and
net exports

Three experiments
Three experiments
Fiscal policy at home
Fiscal policy abroad
An increase in investment demand
1. Fiscal policy at home
An increase in G
or decrease in T
reduces saving.

Results:

I 0
NX S 0

Three experiments
2. Fiscal policy abroad

Expansionary fiscal
policy abroad raises
the world interest rate.

Results:

I 0

NX I 0

Three experiments
3. An increase in investment demand

EXERCISE:
Use the model to
determine the impact
of an increase in
investment demand on
NX, S, I, and net
capital outflow.

Three experiments
An increase in investment demand

ANSWERS:
I > 0,
S = 0,
net capital
outflows and
net exports
fall by the
amount I

Summary

Net exports--the difference between

exports and imports
a countrys output (Y )
and its spending (C + I + G)

Net capital outflow equals

purchases of foreign assets
minus foreign purchases of the countrys assets
the difference between saving and investment